When you sell your home, there’s a possibility that you may earn a profit from the sale. This sounds like a great thing, of course, because it means more money in your pocket. However, keep in mind that you may be subject to capital gains tax. The good news is that there are some exemptions and things you can do to avoid paying them altogether or minimizing the amount you pay. Keep reading to learn more about capital gains tax and how to avoid them.
So, what is the capital gains tax?
First things first, let’s recap what capital gains tax is, so you’re up to speed. When you own something worth a lot of money, such as investments, a car, a stock, a bond, or real estate, that’s considered a capital asset. If you earn a profit from said asset, such as when you sell your home for more than what you paid for it, that’s called a capital gain, and you’re required to report it to the Internal Revenue Service (IRS). The capital gains tax is a tax you pay on that earned profit. You can get an estimate of your capital gain by subtracting the purchase price of your home from the sale price.
There are two types of capital gains: short-term capital gains and long-term capital gains, depending on how long you’ve owned the asset. You’ll pay a short-term capital gains tax if you owned it for less than a year. If you owned it for more than one year, you’ll be subject to the long-term capital gains tax instead. Long-term capital gains tax is typically lower than short-term capital gains tax. The exact tax rate for each will depend on your tax bracket. It can range from zero to 20%, depending on your income.
How to avoid paying the capital gains tax
If you’re a single tax filer, you can be exempt from paying capital gains tax for up to $250,000. For married couples filing jointly, the exemption jumps up to $500,000. That means that, let’s say, you file your taxes as a single person, and you sold your home for $600,000, but you bought it for $300,000. That equals $300,000 in profit, but because of the $250,000 exemption, you’ll only have to pay capital gains tax on $50,000.
That said, there are some criteria you need to meet to qualify for this exemption, which are:
- You must have owned the home for at least two years in the last five years before selling it.
- You must have lived in the home for at least two years in the previous five years before you sold it. The years don’t have to be consecutive or a single block of time.
- You can’t have already taken advantage of the capital gains exemption within the last two years.
Other ways to avoid paying capital gains tax
- Make home improvements—If you make any improvements or renovations to your home, be sure to keep records of it all. Any changes you make to increase the property’s value add to the property’s total cost, decreasing the amount of profit earned, which means fewer capital gains tax to pay.
- Research other exceptions—You may also qualify for the full or a partial capital gains tax exemption if you fall under special circumstances such as going through a separation or divorce, the death of a spouse, your previous home was destroyed, you’re a service member, or if the reason for your home sale is a work or health related move. Check out the IRS Publication 523 for more details on special circumstances.